Negotiating Contractual Indemnity in M&A Deals:

Transactional and Litigation Considerations Structuring Terms to Minimize Financial Risks, Measuring Damages in the Event of Breach

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THURSDAY, MAY 21, 2015

Presenting a live 90-minute webinar with interactive Q&A

Frank C. Koranda, Jr., Partner, Polsinelli, Kansas City, Mo.

Lisa R. Stark, Partner, K&L Gates, Wilmington, Del.

Brandon Vongsawad, Kirkland & Ellis, Los Angeles

Frank Dery, Director, PricewaterhouseCoopers, Chicago

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INDEMNIFICATION

What Is It?

A contractual obligation by one party to pay or compensate for the Losses,

Damages or other liabilities incurred by another party

Indemnity shifts risk between parties to an agreement as part of an integrated

risk allocation system, including reallocation of economic value

Sample Indemnification

Provision

ABA Publishing, Model

Stock Purchase Agreement,

2nd Edition

Sellers, jointly and severally, shall indemnify and hold harmless Buyer, the Acquired Companies,

and their respective Representatives, shareholders, Subsidiaries, and Related Persons (collectively,

the “Buyer Indemnified Persons”) from, and shall pay to Buyer Indemnified Persons the amount

of, or reimburse Buyer Indemnified Persons for any Loss that Buyer Indemnified Persons or any of

them may suffer, sustain, or become subject to, as result of, in connection with, or relating to:

(a) any Breach of any representation or warranty made by Sellers in (i) this Agreement or the

Disclosure Letter (without giving effect to any supplement to the Disclosure Letter), (ii) any

supplement to the Disclosure Letter, (iii) the certificate delivered pursuant to Section 8.3 (without

giving effect to the words “in all material respects” in Section 8.1(a)), or (iv) any other certificate,

document, or other writing delivered be Sellers pursuant to this Agreement;

(b) any Breach of any covenant or obligation of any Seller in this Agreement or in any certificate,

document, or other writing delivered by any Seller pursuant to this Agreement;

(c) any claim by any Person for brokerage or finder's fees or commissions or similar payments

based upon any agreement or understanding made, or alleged to have been made, by any such

Person with any Seller or an Acquired Company (or any Person acting on their behalf) in

connection with any Contemplated Transaction;

(d) (i) any Taxes of any Acquired Company not reflected on the Closing Date Balance Sheet

relating to periods on or prior to the Closing Date, and (ii) any liability of any Acquired Company

for Taxes of any other Person, as transferee or successor by Contract or otherwise;

(e) any product shipped or manufactured by, or any services provided by, any Acquired Company,

in whole or in part, prior to the Closing Date; or

(f) any matter disclosed in Part 11.2(f).

5

Indemnification Coverage

TYPES OF DAMAGES

Reps and warranties

Covenants and agreements

Indebtedness

Taxes

Retained liabilities

Special indemnities

Definition of

“Losses” or “Damages”

Pro-Buyer

Expansive litany of types of Losses

Arising under, in connection with or related to the underlying

indemnification obligation

Include expenses for investigation and defense of any claim and pursuit of

claim against Seller

Pro-Seller

Limited to out-of-pocket, actual and reasonable fees and expenses

Must directly result from the underlying indemnification obligation

6

Financial Statements

REPRESENTATIONS AND WARRANTIES

Types of Financial Statements

Books and Records

GAAP versus Historical Company Policies and Principles

“Fairly Presents”

Interim Statements – year-end adjustments and footnotes

Specific Accounting

Representations

Financial Statements

Accounts Receivable

Accounts Payable

Inventory

Undisclosed Liabilities

Common Representations

Organization Authorization/Enforceability

Noncontravention Capitalization/Subsidiaries

Compliance with Laws Title to Assets

Taxes Contracts

Labor/Benefits Absence of Changes

Customers/Suppliers Affiliate Transactions

Environmental Matters Intellectual Property Matters

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Caps and Baskets

LIMITATIONS

Carve-Outs for fundamentals, special circumstances, specified liabilities

Tipping Basket versus Deductible

Uncapped and indefinite obligations unenforceable (Cigna Health and Life

Insurance Co. v. Audax Health Solutions, Inc., 107 A.3d 1082 (Del. Ch. 2014)

Basic Cap often limited to escrow

Dependent upon the size of the Deductible, presence of a Mini-Basket and

size of the deal

Materiality Scrapes

Materiality scrape for determining breach

Materiality scrape for measuring damages

Exceptions to materiality scrapes

MAE qualifiers – when do they belong in reps/warranties at all

Other Limitations

Tax Benefits offsets

Insurance and other proceeds offsets

Mitigation requirements

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LIMITATIONS

Purchase Price Adjustment

and Double-Dipping

“No Purchaser Indemnified Party shall make any claim for indemnification

under this Article X in respect of any matter that is taken into account in Section

2.4 (working capital adjustment).”

Disclosure During

Executory Period

Effect – Do schedule updates effect indemnity

Timing – When does breach need to arise

Exclusive Remedy

“The sole and exclusive remedy for any breach or failure to be true and

correct of any representation or warranty shall be indemnification made in

accordance with Article X. In furtherance of the foregoing, the parties hereby

waive, to the fullest extent permitted by law, any and all other rights, claims,

and courses of action under any federal, state or local law.”

Sandbagging

The moral highground and middle of the road position

Knowledge as a first line of defense

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Survival in Delaware

LIMITATIONS

Unlike some other states, Delaware allows parties to contractually shorten the statute of limitations (which is 3 years for breach of contract and fraud in DE) so long as reasonable

Parties may contractually extend the statute of limitations (without signing “under seal”) for up to 20 years for contracts involving more than $100,000 The statute may be extended for:

a specific period of time

a period of time defined by reference to some other event, action, document or statute

an indefinite period, which will be construed as 20 years

After Cigna, indefinite (i.e., 20 year survival) may not be enforceable

SOL amendments recently applied retroactively

Similar to a statute of limitations, litigation must be commenced prior to the end of the survival period (notice is not in and of itself sufficient) unless the agreement specifically provides otherwise

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LIMITATIONS

What might work after

Cigna?

Indemnifications obligations that are temporally limited and/or do not put all of the merger consideration at risk of clawback

Side letters or joinders (individual agreements by stockholders to assume indemnities)

Contingent payment provisions – The merger agreement might specify that the target’s stockholders have a right to receive some specified amount of merger consideration if, and only if, the stockholders sign letters of transmittal containing an agreement to be bound by the indemnification obligations. The LoT should be attached to the merger agreement.

Closing condition that gives the Buyer the right to walk if a specified percentage of target stockholders don’t agree to the LoT – Language in LoT should be clear that stockholders can’t be forced to sign but that the deal will not close unless enough sign

Escrow or other holdback to satisfy indemnification claims

Stock purchase agreement or asset purchase agreement

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Fraud Carve-Outs

INDEMNIFICATION CARVE-OUTS

Actual fraud:

Making a (material) rep that is false; Knowing (in some jurisdictions, a reckless disregard for the accuracy or inaccuracy of a statement will suffice) that the rep is false; Making it with the intent to deceive the other party; Justifiable reliance on the rep by the other party; and The other party was injured as a result of the false rep

Constructive or Equitable Fraud

Generally same elements as ‘actual fraud’ or ‘fraud’ but ‘constructive

fraud’ “may result from reckless and heedless rep not made with a deliberate

intent to deceive”

Much lower standard and scienter is not required, but in Delaware a

special relationship of trust or fiduciary relationship must exist between

parties

Jurisdictional analysis is necessary to determine whether constructive fraud is

a recognized cause of action and whether actual fraud includes reckless

misrepresentations – other options include negligent misrepresentation

Other Carve-Outs Intentional, willful or negligent misrepresentation

Define “Intent” as intent to deceive

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RAA and Non-Reliance

Language

INDEMNIFICATION CARVE-OUTS

What should non-reliance cover to minimize Seller’s liability for fraud based on extra-contractual statements:

Seller is making no express or implied representations or warranties

Seller is making no representations or warranties as to the accuracy or completeness of information provided by Seller to Buyer

Buyer is not relying on any representations, warranties or omissions of the Sellers

What is insufficient

Standard integration clause

Statement that Seller is making no express or implied representations or warranties

Limitations

Non-reliance language will not preclude dismissal of federal securities

fraud claim for cases brought in the Third Circuit. Universal American

Corp. v. Partners Healthcare Solutions Holdings, L.P. No. 13-1741,

2014 WL 3703867 (D. Del. July 24, 2014).

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ESCROWS AND CLAIM PROCESS

Key Considerations

Escrow – First source? Sole source?

Carve-Outs – fundamental reps, taxes, special indemnities, covenants

Spillover claims – recourse for claims outside of escrow

Escrow versus Holdback versus Seller Note

Earnout – Does the acquirer have a responsibility to maximize value of the

earnout post-closing

Rollover Equity

‘Naked’ indemnification obligations

Third Party Claims Process

Who controls defense

Who has more at risk

Reservation of rights/acknowledgment of responsibility

Exclusions: injunctive relief, government claims, criminal/quasi-criminal, failure to prosecute, other (adverse to business or reputation, adverse precedent)

Requirement of posting a bond or other security upon assumption of defense

Wrapping up third-party claims – consent and exceptions

Final Adjudication

Settlement

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Sandbagging

2013 PRIVATE TARGET M&A DEAL POINTS STUDY

Pro-Sandbagging – 41% included Pro-Sandbagging (right to indemnification

not affected by investigation or knowledge)

Anti-Sandbagging – 10% included Anti-Sandbagging (no indemnification if

party seeking indemnification had knowledge of such breach)

49% silent

Survival Periods

Majority survival periods between 12-18 months with fundamental Carve-Outs

Baskets

59% Deductible/Threshold

32% Dollar 1/Tipping

5% Hybrid

4% No Basket

Fundamental Representations are typically excluded

Most Baskets apply to reps and warranties; some apply to indemnity generally

30% have Mini-Basket

Most Baskets range from .5%-1% of Transaction Value

15

Double Materiality Scrape

2013 PRIVATE TARGET M&A DEAL POINTS STUDY

28% have Scrapes

41% of Scrapes limited to calculation of Losses; 59% of Scrapes apply to

Losses and truth of the rep

Caps

89% had Caps less than purchase price

Mean – 16.6% of Transaction Value

Median – 10.0% of Transaction Value

Minimum – 2.7% of Transaction Value

Maximum – 115% of Transaction Value

Fundamental Representations are typically excluded

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Key Considerations

CREDITWORTHINESS OF INDEMNITORS

Who is the Seller/Indemnitor

Number of Sellers

Domestic or Foreign Sellers

Individuals

Entities

reps and warranties

actual entity with assets to backstop/be put at risk

currently solvent/able to make cash indemnification payments (debt

restrictions on payments)

future prospects of indemnitor

guarantor

Buyer Perspective

Company versus individual Seller reps and warranties

Several versus Joint and Several

Carve-Outs for specific items (Environmental, Taxes, Employee Benefits,

Specific Indemnities)

Seller Perspective

Several versus Joint and Several

Seller will typically want to limit any obligations to the legal owner of the

target company– especially if Seller is solvent and is an operating entity with

real assets

If there is an escrow, Seller will want to limit its exposure to the amount of

the escrow in all cases 17

TYPES OF DAMAGES RECOVERABLE

Types

Direct Consequential Punitive

Indirect Special Speculative

Incidental Lost Profits Multiples

Considerations

Weil Gotshal & Manges LLP article “Reassessing the Consequences of Consequential Damage Waivers in Acquisition Agreements”

Loss of Value Concepts (“as is,” “where is” or “as warranted”)

Asset value – how to calculate fair market value

Earnings value (LTM EBITDA, Projected EBITDA, Other)

When to use transaction methodology versus a new valuation methodology

Net Assets, Multiple of Sales, Discounted Cash Flow, Comparables

Breach of a specific or general warranty, and connection to Basket/Cap

Agree in advance to preferred approach and document the decision

Prevailing Party Provision – In a dispute the loser pays

Who can the Damages be collected against

Seller

Stockholder who did not participate in the wrongdoing

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M&A INSURANCE

The Insured Buyer or Seller can be insured

Policy can be in lieu of, or in addition to, Seller indemnification

Bridging the Gap

Can provide a source of recovery where indemnification is otherwise unavailable

Additional protection beyond indemnity Cap and survival limitations

Insurer generally amenable to a “full” Materiality Scrape

Improving collectability (compare to joint and several liability)

Protect key relationships with “friendly” indemnitors (e.g., management sellers)

Smaller escrow required (cover Deductible and special indemnities)

“Clean Exit” - Allows institutional investors to distribute transaction proceeds earlier, with limited potential for clawback

Avoid post-closing adversarial proceedings/litigation with Seller

Ability to assign policy to affiliates, collaterally to lenders and to future Buyer

Improved Buyer position in an auction

Economics

Premium: 1-6% of coverage

Retention: The Deductible under the policy (1-3% of enterprise value);

exclusive of any Indemnification Basket/Deductible; Step-Downs

Limits: Amount of coverage under the policy (insurance towers)

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M&A INSURANCE LIMITATIONS

Coverage Limitations

Pre-existing conditions (e.g. known environmental contamination)

Express Sandbagging (i.e. actual and potentially constructive knowledge of

breach will be excluded)

Coverage for punitive damages, governmental penalties (e.g. reportable

transactions), fraud

The retention applies to all reps and warranties (including fundamentals)

Covenant breaches will not be covered

Other Disadvantages

Providing the legal, accounting and tax due diligence reports to the insurer in connection with the underwriting process almost always waives the privilege

Seller versus Buyer policies

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INDEMNIFICATION CONSIDERATIONS

What parties are being indemnified

What is the scope of covered losses

Are legal fees and costs included within the scope of indemnity

Does the indemnity extend to liabilities in addition to losses or damages

Are there baskets and caps

Is the indemnity consistent with any insurance products and other contractual

provisions

Is the indemnification the exclusive source of rights and remedies

What is the survival period and when does that commence

What carve-outs and exclusions to the obligations exist

Does the indemnity cover direct and third party claims

What is the indemnity procedure and who controls the defense

Is the indemnifying party creditworthy; any guarantees or other parties needed

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